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Education Planning

Coverdell Education Savings Account (Formerly Called an “Education IRA”)

A Coverdell Education Savings Account (ESA) is a trust that is created exclusively for the purpose of paying certain education expenses of a named beneficiary. The Coverdell ESA balance must be distributed to the beneficiary within 30 days after he turns age 30, unless transferred to a family member’s Coverdell ESA. Additional contributions can’t be made after the beneficiary turns age 18. Distributions in excess of qualified educational expenses are taxable and generally are subject to a 10% additional tax unless one of several exceptions applies.

The annual Coverdell ESA contribution limit is $2,000. The phase-out range for married taxpayers filing a joint return is $190,000 to $220,000 of modified AGI.

Allowable annual contributions to tax-exempt Coverdell ESAs are not deductible, but distributions for an individual beneficiary’s qualified education expenses are tax-free. The definition of qualified education expenses will include the following:

Elementary (including kindergarten) and secondary public, private, or religious school tuition and expenses, including tutoring, room and board, uniforms, and extended-day program costs, and special needs services for a special needs beneficiary.

The purchase of computer technology or equipment (including software), and internet access and services, if they are to be used by the beneficiary and his family during any of the beneficiary’s school years.

Coverdell ESA contributions for special-needs beneficiaries will be allowed after they attain age 18, and deemed distributions of education IRA balances will not occur when those beneficiaries reach age 30.

Corporations and other entities, including tax-exempts will be able to contribute to Coverdell ESAs, regardless of the entity’s income. These contributions will be allowed regardless of the income of the child’s parents.

Taxpayers will be able to claim American Opportunity Credit and Lifetime Learning Credits for a student in a year when excluded distributions are made from a Coverdell ESA for that student, as long as credits are not claimed for amounts paid with tax-free distributions.

Illinois “Bright Start” College Savings Plan

The Illinois “Bright Start” college savings plan is being offered under provisions of Section 529 of the Internal Revenue code. Bright Start works by investing in mutual funds. Illinois has contracted with Oppenheimer Funds to manage the investment trust.

Illinois also has “College Illinois” which has been around for a few years. Prepaid tuition through the college Illinois plan is a less aggressive investment, a defined benefit plan that acts as a hedge against tuition inflation by allowing parents and grandparents to lock in current tuition rates for state schools.

Section 529 college savings plans offer contribution advantages over another option called Coverdell Education Savings Accounts with their low annual deposit limits of $2,000.

Contributions of up to $13,000 a year and $320,000 over the life of the account are permitted in Bright Start.

Provisions for lump sum contributions as large as $65,000 ($130,000 for married couples) without gift tax penalties are also included in the tax code, in case grandma and grandpa want some of their nest egg to go toward educating their grandchildren.

Private institutions may be sponsors of prepaid tuition programs. The definition of a “Qualified Tuition Program” will include certain prepaid tuition programs established and maintained by eligible educational institutions (including private institutions) that satisfy the requirements under code section 529.

Exclusion for qualifying payouts. Distributions will be excluded from gross income to the extent they are used to pay for qualified higher education expenses. The exclusion will apply to payouts from qualified state tuition programs, and to payouts from qualified tuition programs established and maintained by entities other than a state.

Qualified higher education expenses will include special needs services for special needs beneficiaries.

For the exclusion for distributions from qualified tuition plans to pay for qualified higher educational expenses, including room and board, the maximum room and board allowance will be the actual amount charged by the educational institution for room and board.

During the same tax year, taxpayers will be able to claim the American Opportunity Credit or Lifetime Learning Credit and exclude amounts distributed from a qualified tuition program for the same student as long as the distribution is not used for the same expenses as which a credit will be claimed.

The definition of a family member for purposes of beneficiary changes and rollovers will include first cousins of the original beneficiary.

Coverdell ESAs and Qualified Tuition Programs offer essentially the same income tax benefit, namely tax-free earnings if payouts are made for qualified educational purposes. However, each offers a unique combination of benefits and limitations. For example, a Coverdell ESA can be used for elementary and secondary school expenses or college costs, but annual contributions are limited $2,000 per beneficiary and an individual’s contributions are subject to AGI phase outs. The qualified tuition program, on the other hand, does not restrict contributions, but must be used for higher education. The best savings vehicle ultimately will depend on the needs of the donor and the beneficiary who will receive the education.

Unlike custodial mutual funds in his name that become his property at age 18, college savings plans like Bright Start remain in the name of the adult who opened the account. The beneficiary may be changed to another family member, including adults who may want to pursue an advanced degree.

The account is also not included as part of the owner’s taxable estate.

However, withdrawals for nonqualified education expenses incur a federally mandated 10% penalty on top of the income being taxed at the owner’s higher rate.

Most Section 529 savings plans offered by other states are open to out-of-state residents.

Bright Start applications and other information are available at 877-43-BRIGHT or online at www.brightstartsavings.com.

Tax Credits for Higher Education

An individual taxpayer may claim an income tax credit for the American Opportunity Credit (formerly called the Hope Credit) and the Lifetime Learning Credit for higher education expenses at accredited post-secondary educational institutions paid for themselves, their spouses, and their dependants. The American Opportunity Credit is available only for qualified expenses of the first four years of undergraduate education. The Lifetime Learning Credit is available for qualified expenses of any post-high school education at eligible educational institutions. Both credits cannot be claimed in the same tax year for expenses of any one student, and there are phases-outs for higher income taxpayers.

For 2009 and 2010, the American Opportunity Credit phase-out ratable for taxpayers with modified AGI of $80,000 to $90,000 ($160,000 to $180,000 for joint filers). The Lifetime Learning Credit phases out ratably for taxpayers with modified AGI of $50,000 to $60,000 ($100,000 to $120,000 for joint filers) for 2009 and 2010.

For 2009 and 2010, the American Opportunity Credit will be 100% of up to $2,000 of qualified higher education tuition and related expenses plus 25% of the next $2,000 of such expenses. The Lifetime Learning Credit, which can be used in subsequent years, could save you $2,000 a year in taxes.

The recently enacted “American Recovery and Reinvestment Act of 2009” (the 2009 economic stimulus act) includes a measure aimed at making college more affordable for low and moderate-income students. The new provision temporarily enlarges the Hope tax credit (renamed the American Opportunity tax credit) for students from middle-income families and partially extends this tax credit for the first time to students from lower-income families. Here are the details:

• The new law creates a new American Opportunity tax credit for 2009 and 2010, replacing and expanding the Hope tax credit for those years.
• The maximum amount of the American Opportunity tax credit is $2,500 (up from a maximum credit of $1,800 under the Hope credit). The credit is 100% of the first $2,000 of qualifying expenses and 25% of the next $2,000, so the maximum credit of $2,500 is reached when a student has qualifying expenses of $4,000 or more.
• While the Hope credit was only available for the first two years of undergraduate education, the American Opportunity tax credit is available for up to four years.
• Under the Hope credit, qualifying expenses were narrowly defined to include just tuition and fees required for the student’s enrollment. Textbooks were excluded, despite their escalating cost in recent years. The American Opportunity tax credit expands the list of qualifying expenses to include textbooks.
• The Hope credit was nonrefundable, i.e., it could reduce your regular tax bill to zero but could not result in a refund. This meant that if a family did not owe any taxes it could not benefit from the credit, which prompted critics to argue that the credit was thus denied to the very families most in need of help affording college. The American Opportunity tax credit addresses this criticism to a degree by providing that 40% of the credit is refundable. This means that someone who has at least $4,000 in qualified expenses and who would thus qualify for the maximum credit of $2,500, but who has no tax liability to offset that credit against, would qualify for $1,000 (40% of $2,500) refund from the government.
• The Hope credit was not available to someone with higher than moderate income. Under the credit’s “phaseout” provision, taxpayers with adjusted gross income (AGI) over $50,000 (for 2009) saw their credits reduced, and the credit was completely eliminated for AGIs over $60,000 (twice those amounts for joint filers). Under the American Opportunity tax credit, taxpayers with somewhat higher incomes can qualify, as the phaseout of the credit begins at AGI in excess of $80,000 ($160,000 for joint filers).

Exclusion for Employer-Paid Education

Employers can set up educational assistance programs under which employees can receive up to $5,250 per year of educational assistance tax-free, whether or not job-related. Under pre-2001 Act law, the exclusion did not apply for courses beginning after December 31, 2001 or to graduate-level courses.

The 2001 Act made the exclusion for employer-paid education permanent and expanded it to employer-paid graduate education.

Above-the-Line Deduction for Qualified Higher Education Expenses

For tax years beginning after December 31, 2001, the 2001 Act allows a taxpayer to deduct the qualified tuition and related expenses paid by the taxpayer as an “above-the-line” deduction (as an adjustment to gross income to arrive at Adjusted Gross Income) that can be claimed by taxpayers who do not itemize.

The higher education expense deduction may not exceed the “applicable dollar limit” for the tax year. The applicable dollar limit caps the amount of the deduction for the tax year and sets Adjusted Gross Income limitations on who can claim the deduction.

Student Loan Interest

For 2001 and later years, individuals can deduct a maximum of $2,500 for interest paid on qualified higher education loans. The deduction is claimed above-the-line.

For tax years ending after 2001, the income phase-out ranges for eligibility for the student loan interest deduction increased to $60,000 to $75,000 for 2009 ($60,000 to $75,000 for 2010) for single taxpayers and to $120,000 to $150,000 for 2009 ($120,000 to $150,000 for 2010) for married taxpayers filing joint returns.